Contrary to my belief at a young age, a mutual fund is not when you and a friend decide to buy something together. A mutual fund is a professionally managed pool of securities (stocks) that investors can buy shares in. Mutual funds are not traded on a stock exchange, though their portfolios often are. Mutual funds pay out the money they make to investors via dividends or interest. Mutual funds come in many shapes and sizes, and can be focused on one industry area, or cover a wide range of global securities.
For individuals who want to invest in the stock market but lack expertise, mutual funds are a popular investment. That way, someone with even $500 can invest and own a tiny percentage of a large pool of investments. Mutual funds offer diversification, which is important in investing. If an individual only has a limited amount of money to invest, they can only buy a small amount of stocks, and price changes in even one of those stocks would hurt them a great deal. Mutual funds are legally required to have a varied portfolio of investments, which makes them less susceptible to losing your money. Mutual funds stand another advantage over small-time investors due to their enhanced market expertise. It is nearly impossible for a non-professional investor to succeed in foreign stock markets, as the rules are different and they likely lack sufficient background knowledge. Mutual funds employ investment professionals who have a deep knowledge in that fund’s area of investment. A mutual fund describes what their investment strategy and area of focus is in their prospectus.
Mutual funds can come in a few different structures, the most common of which is the open-ended fund. An open-ended mutual fund can be bought or sold directly from the fund, and is required to buy back shares when investors wish to sell. Shares of open-ended funds are priced at Net Asset Value (NAV), which means that the fund will give you as much money as the mutual fund is currently worth. This is the value of all stock (or other investments), minus any debts the fund may have. As the name might imply, open-ended mutual funds have an open-ended amount of shares they can issue. If lots of people are trying to invest in the fund, they can issue more shares and reinvest the money. If a fund becomes too large, the manager can decide to close it off to new investors. On the other hand, a closed-end fund has a fixed amount of shares, meaning that if a lot of people are trying to buy shares the price will go up. Closed-end funds are traded on an exchange, and price increases can be due to demand rather than the actual value of the fund. Closed-end funds are not very popular.